Today’s word of the day: Arrears.
Back when I practiced law, people would come into my office all the time with legal documents they didn’t understand. Who could blame them? These docs were full of arcane language and gobbledygook words. Arrears was one of those words that many people, including a lot of small business people, struggled with.
And that’s too bad, because if you are in arrears, you are in trouble. Put simply, arrears means being behind on scheduled payments. Like most legal matters, being in arrears is also a bit more complicated than that basic definition.
So let’s see what it really is, and–more importantly–what to do about it.
What Exactly is the Definition of In Arrears?
Legally speaking, in arrears (not “arrear”) is a term that refers to the timeliness of payments—or, rather, the lack thereof. In plain speak, in arrears is when you are late on a regularly due payment.
Accordingly, to “pay in arrears” means that you are paying a bill after its due date. Being 12 months in arrears means you are a year behind in payments at the end of the period. If you have ever missed a mortgage payment, that is arrears.
Let’s look at that definition a little more closely. Three factors must be present for an obligation to be in arrears. For something to fall into arrears, it must be:
- A recurring payment due over a period of time: A monthly payment, for example, could fall into arrears.
- Part of an ongoing contract: This could be anything from a business loan to a lease on warehouse space.
- A month or more behind: Technically, if you missed a scheduled payment but, say, made it up a week later, you would be a week in arrears (or, a thesaurus definition or other synonym on a word list might be “arrearage”)—but arrears typically refers to a missed recurring payment that is a month or more behind.
Does Arrears Apply to a One-Time Payment?
Arrears does not typically apply to a one-time payment. Say that you wrote a check for a one-time purchase of inventory, and the check bounced. That payment would be due, but not in arrears, because arrears refers to an ongoing financial obligation that is not being regularly serviced—not a one-time payment.
Types of Payments That Can Be in Arrears
Any ongoing payment or financial obligation that is not paid by the regular due date would be considered in arrears. This could include:
- Mortgage payments
- Lease obligations
- Child support
- Credit card payments
- Automobile payments
- Other ongoing monthly payments
The Problem with Paying in Arrears
If you have ever fallen behind on a regular payment, i.e., gone into arrears, you know how difficult it can be to get out of that unenviable situation. The reason is that arrears accrues from the due date of the missed obligation.
So even if you have the cash to start paying again—it goes towards those late bills first. What does that mean? You’re not paying your current bill and are, thus, late on that (unless, of course, you have the cash for all late and current payments).
Interest starts to compound from that old date too, which is why falling into arrears can be so financially dangerous. Interest upon interest is not easy to deal with. Getting caught up is difficult; it can affect your business, your cash flow and whether you can pay employees, your personal and business credit rating, everything.
As such, when you analyze how much money you will need to catch up, do not fail to take interest rates into account.
Example of Paying in Arrears
Say that you leased a vehicle for your business and you owe $500 / month on the car. Then, further assume that a couple of years in, things at work got tight and you missed two payments. You would be $1,000 in arrears. Add in, say, $100 in interest, and things really start to get rough.
Unfortunately, when you start to pay $500 a month again, it’s applied to that old obligation, and so, even when you do pay $500 the next month, you would still be considered late because you didn’t pay the current month on time (that recent payment was applied to the old, still-due, obligation.) And again, there is also interest accruing on the late payment.
Or, what if the next month, you pay $1,300, would you be free and clear? Nope, no way. You would still be $200 in arrears (excluding interest). Here’s why: The first $1,000 you pay would be applied to the arrears. The next $300 would be applied to your current obligation of $500. As such, as you can see, you would still be short by $200 and that will become your new arrearage.
So you can see what a hole you dig for your small business when you fall into arrears. Usually, the only way to get out is to make extra payments until you get caught up. We’ll go over that and your other options next.
Three Options When You Fall into Arrears
There are all sorts of reasons why a small business might miss a payment and end up in arrears. Sure, it could be simply that it was intentional; that the financial obligation just could not be met at that time. But also, it could be that an invoice was missed or never sent. Maybe a bank account was closed and the payment was made off that account by accident. Mistakes happen.
The good news is that you do, in fact, have some options when you fall behind in payments.
1. Catch Up
Whatever the reason, if you missed payments over a period of time, you owe that entity money. Obviously, the best and easiest way to get out of arrears is to catch up. Pay the entire amount (and any interest) past due, however difficult that may be, and move on.
That is, of course, unless you are able to:
Depending on how much you are behind, and for how long, it may be possible to negotiate your way out of the debt. Creditors do not like having late payments on the books. Accordingly, they may be more amenable to a negotiated solution than you may think.
But do please note this caveat: If you attempt to get out of the debt for less than you owe, do not expect the creditor to want to maintain an ongoing working relationship with you. Negotiating may indeed get you out of a financial bind, but it will also likely spell the end of the relationship.
If you are able to negotiate the arrears, it is vital that you get any agreement in writing, and make sure to get the creditor’s promise that they will report you or your business as current to any credit reporting agencies.
3. File Bankruptcy
There are several kinds of bankruptcy filings a small business may choose to deal with this problem:
- Chapter 7 or “liquidation”: Here, you might be able to wipe out the arrears altogether, but you also might have to close up shop. This is a question for you to discuss with a bankruptcy lawyer.
- Chapter 11 and Chapter 13: These are different sorts of bankruptcies that offer repayment plans, depending on your amount of debt and your business type. In either case, your arrears would be rolled into a larger repayment plan that attempts to settle all of your debts. You may or may not have to pay everything back 100 percent. Again, it depends on the situation—and you’ll want to consult with a lawyer to determine whether these types of bankruptcies are the right move for your business.
Avoid Arrearage Issues Going Forward
Arrears can be a hassle for both the small business owner as well as the creditor. No one likes owing money, but equally, being owed money can also be a hassle. You should therefore seek to avoid both. Here are some ways to do that:
- First, have your accountant or bookkeeper review your accounts payable and be sure to keep them up to date. Don’t fall into arrears!
- Second, review also your accounts receivable to ensure that no account is falling too far behind. If someone is, work to nip it in the bud.
- Finally, make on-time payments a habit and priority. That way, arrears will be something you read about in an article but don’t have to deal with in real life!
The Bottom Line: Falling into Arrears is No Fun
Arrears are any regular payments that are considered late. If you miss (or are “behindhand” on) a payment, interest will begin to accrue and anything you pay back will go to the oldest bill first.
And if you do find yourself in this situation? There are a few different ways out. While it’s not a fun process, it’s usually doable. So, review your options with your accountant or lawyer and come up with a plan to get out of arrears as fast as you can.